Key Concepts and Skills. Good Decision Criteria. Chapter Outline. Project Example Information 1-1. Chapter 8

Size: px
Start display at page:

Download "Key Concepts and Skills. Good Decision Criteria. Chapter Outline. Project Example Information 1-1. Chapter 8"

Transcription

1 Key Concepts and Skills Chapter 8 Net Present Value and Other Investment Criteria Understand the payback rule and its shortcomings Understand accounting rates of return and their problems Understand the internal rate of return and its strengths and weaknesses Understand the net present value rule and why it is the best decision criteria Net Present Value The Payback Rule Chapter Outline The Average Accounting Return The Internal Rate of Return The Profitability Index The Practice of Capital Budgeting Good Decision Criteria We need to ask ourselves the following questions when evaluating decision criteria Does the decision rule adjust for the time Does the decision rule adjust for risk? Does the decision rule provide information on whether we are creating value for the firm? Example Information You are looking at a new project and you have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000 Your required return for assets of this risk is 12%. Net Present Value The difference between the market value of a project and its cost How much value is created from undertaking an investment? The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment. 1-1

2 Decision Rule If the is positive, accept the project A positive means that the project is expected to add value to the firm and will therefore increase the wealth of the owners. Since our goal is to increase owner wealth, is a direct measure of how well this project will meet our goal. Computing for the Using the formulas: = 63,120/(1.12) + 70,800/(1.12) ,080/(1.12) 3 165,000 = $12, Using the calculator: CF 0 = -165,000; C01 = 63,120; F01 = 1; C02 = 70,800; F02 = 1; C03 = 91,080; F03 = 1; ; I = 12; CPT = 12, Decision Criteria Test - Does the rule account for the time Does the rule account for the risk of the cash flows? Does the rule provide an indication about the increase in value? Should we consider the rule for our primary decision criteria? Payback Period How long does it take to get the initial cost back in a nominal sense? Computation Estimate the cash flows Subtract the future cash flows from the initial cost until the initial investment has been recovered Decision Rule Accept if the payback period is less than some preset limit Computing Payback For the Assume we will accept the project if it pays back within two years. Year 1: 165,000 63,120 = 101,880 still to recover Year 2: 101,880 70,800 = 31,080 still to recover Year 3: 31,080 91,080 = -60,000 project pays back during year 3 Payback = 2 years + 31,080/91,080 = 2.34 years Decision Criteria Test - Payback Does the payback rule account for the time Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision criteria? 1-2

3 Advantages and Disadvantages of Payback Advantages Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity Disadvantages Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against longterm projects, such as research and development, and new projects Average Accounting Return There are many different definitions for average accounting return The one used in the book is: Average net income / average book value Note that the average book value depends on how the asset is depreciated. Need to have a target cutoff rate Decision Rule: Accept the project if the AAR is greater than a preset rate. Computing AAR For the Assume we require an average accounting return of 25% Average Net Income: ($13, , ,100) / 3 = $15,340 AAR = $15,340 / 72,000 =.213 = 21.3% Decision Criteria Test - AAR Does the AAR rule account for the time Does the AAR rule account for the risk of the cash flows? Does the AAR rule provide an indication about the increase in value? Should we consider the AAR rule for our primary decision criteria? Advantages and Disadvantages of AAR Advantages Easy to calculate Needed information will usually be available Disadvantages Not a true rate of return; time value of money is ignored Uses an arbitrary benchmark cutoff rate Based on accounting net income and book values, not cash flows and market values Internal Rate of Return This is the most important alternative to It is often used in practice and is intuitively appealing It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere 1-3

4 IRR Definition and Decision Rule Definition: IRR is the return that makes the = 0 Decision Rule: Accept the project if the IRR is greater than the required return Computing IRR For the If you do not have a financial calculator, then this becomes a trial-and-error process Calculator Enter the cash flows as you did with Press IRR and then CPT IRR = 16.13% > 12% required return Profile For the 70,000 60,000 50,000 40,000 30,000 20,000 10, ,000-20, Discount Rate IRR = 16.13% Decision Criteria Test - IRR Does the IRR rule account for the time Does the IRR rule account for the risk of the cash flows? Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria? Advantages of IRR Knowing a return is intuitively appealing It is a simple way to communicate the value of a project to someone who doesn t know all the estimation details If the IRR is high enough, you may not need to estimate a required return, which is often a difficult task Summary of Decisions For the Summary Net Present Value Payback Period Average Accounting Return Internal Rate of Return Accept Reject Reject Accept 1-4

5 vs. IRR and IRR will generally give us the same decision Exceptions Nonconventional cash flows cash flow signs change more than once Mutually exclusive projects Initial investments are substantially different Timing of cash flows is substantially different IRR and Nonconventional Cash Flows When the cash flows change signs more than once, there is more than one IRR When you solve for IRR, you are solving for the root of an equation and when you cross the x-axis more than once, there will be more than one return that solves the equation If you have more than one IRR, which one do you use to make your decision? Another Example Nonconventional Cash Flows Suppose an investment will cost $90,000 initially and will generate the following cash flows: Year 1: $132,000 Year 2: $100,000 Year 3: -$150,000 The required return is 15%. Should we accept or reject the project? Profile IRR = 10.11% and 42.66% $4, $2, $0.00 ($2,000.00) ($4,000.00) ($6,000.00) ($8,000.00) ($10,000.00) Discount Rate Summary of Decision Rules The is positive at a required return of 15%, so you should Accept If you use the financial calculator, you would get an IRR of 10.11% which would tell you to Reject You need to recognize that there are nonconventional cash flows, and that you need to look at the profile IRR and Mutually Exclusive s Mutually exclusive projects If you choose one, you can t choose the other Example: You can choose to attend graduate school next year at either Harvard or Stanford, but not both Intuitively, you would use the following decision rules: choose the project with the higher IRR choose the project with the higher IRR 1-5

6 Period IRR Example With Mutually Exclusive s A % B % The required return for both projects is 10%. Which project should you accept and why? $ $ $ $ $80.00 $60.00 $40.00 $20.00 $0.00 ($20.00) ($40.00) Profiles IRR for A = 19.43% IRR for B = 22.17% Crossover Point = 11.8% Discount Rate A B Conflicts Between and IRR directly measures the increase in value to the firm Whenever there is a conflict between and another decision rule, you should always use IRR is unreliable in the following situations Non-conventional cash flows Mutually exclusive projects Modified Internal Rate of Return (MIRR) Compute IRR of modified cash flows Controls for some problems with IRR Discounting Approach Discount future outflows to present and add to CF 0 Reinvestment Approach - Compound all CFs except the first one forward to end Combination Approach Discount outflows to present; compound inflows to end MIRR will be a unique number for each method, but is difficult to interpret; discount/compound rate is externally supplied Example: MIRR cash flows: Time 0: -$500 today; Time 1: + $1,000; Time 2: -$100 Use combined method and RRR = 11% PV (outflows) = -$ $100/(1.11) 2 = -$ FV (inflow) = $1,000 x 1.11 = $1,110 MIRR: N=2; PV= ; FV=1,110; CPT I/Y = MIRR = 38.2% Profitability Index Measures the benefit per unit cost, based on the time value of money A profitability index of 1.1 implies that for every $1 of investment, we receive $1.10 worth of benefits, so we create an additional $0.10 in value This measure can be very useful in situations in which we have limited capital 1-6

7 Advantages and Disadvantages of Profitability Index Advantages Closely related to, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited Disadvantages May lead to incorrect decisions in comparisons of mutually exclusive investments Capital Budgeting In Practice We should consider several investment criteria when making decisions and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria Quick Quiz Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9% and the required payback is 4 years. What is the payback period? What is the? What is the IRR? Should we accept the project? What should be the primary decision method? When is the IRR rule unreliable? Comprehensive Problem An investment project has the following cash flows: CF0 = -1,000,000; C01 C08 = 200,000 each If the required rate of return is 12%, what decision should be made using? How would the IRR decision rule be used for this project, and what decision would be reached? How are the above two decisions related? 1-7

Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of

Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of 1 Why Use Net Present Value? The Payback Period Method The Discounted Payback Period Method The Average Accounting Return Method The Internal Rate of Return Problems with the IRR Approach The Profitability

More information

Capital Budgeting: Decision. Example. Net Present Value (NPV) FINC 3630 Yost

Capital Budgeting: Decision. Example. Net Present Value (NPV) FINC 3630 Yost Capital Budgeting: Decision Criteria Example Consider a firm with two projects, A and B, each with the following cash flows and a 10 percent cost of capital: Project A Project B Year Cash Flows Cash Flows

More information

Net Present Value (NPV)

Net Present Value (NPV) Investment Criteria 208 Net Present Value (NPV) What: NPV is a measure of how much value is created or added today by undertaking an investment (the difference between the investment s market value and

More information

Key Concepts and Skills. Net Present Value and Other Investment Rules. http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf.

Key Concepts and Skills. Net Present Value and Other Investment Rules. http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf. McGraw-Hill/Irwin Net Present Value and Other Investment Rules 9-1 http://www2.gsu.edu/~fnccwh/pdf/ rwjch5v3overview.pdf Copyright 2010 by Charles Hodges and the McGraw-Hill Companies, Inc. All rights

More information

$1,300 + 1,500 + 1,900 = $4,700. in cash flows. The project still needs to create another: $5,500 4,700 = $800

$1,300 + 1,500 + 1,900 = $4,700. in cash flows. The project still needs to create another: $5,500 4,700 = $800 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project has created: $1,300 + 1,500 + 1,900 = $4,700 in cash flows.

More information

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. A payback period less than the project s life means that the NPV is positive for

More information

Capital Budgeting Tools. Chapter 11. Capital Budgeting. Types of Capital Budgeting Projects. The Basics of Capital Budgeting: Evaluating Cash Flows

Capital Budgeting Tools. Chapter 11. Capital Budgeting. Types of Capital Budgeting Projects. The Basics of Capital Budgeting: Evaluating Cash Flows Capital Budgeting Tools () Payback Period (a) Discounted Payback Period Chapter The Basics of Capital Budgeting: Evaluating s () Net Present Value (NPV) (a) Profitability Index (PI) () Internal Rate of

More information

Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions

Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Understanding Financial Management: A Practical Guide Guideline Answers to the Concept Check Questions Chapter 8 Capital Budgeting Concept Check 8.1 1. What is the difference between independent and mutually

More information

Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization

Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization T9.1 Chapter Outline Chapter 9 Net Present Value and Other Investment Criteria Chapter Organization! 9.1 Net Present Value! 9.2 The Payback Rule! 9.3 The Average Accounting Return! 9.4 The Internal Rate

More information

Chapter 10. What is capital budgeting? Topics. The Basics of Capital Budgeting: Evaluating Cash Flows

Chapter 10. What is capital budgeting? Topics. The Basics of Capital Budgeting: Evaluating Cash Flows Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows 1 Topics Overview and vocabulary Methods NPV IRR, MIRR Profitability Index Payback, discounted payback Unequal lives Economic life 2 What

More information

The Time Value of Money

The Time Value of Money The Time Value of Money Future Value - Amount to which an investment will grow after earning interest. Compound Interest - Interest earned on interest. Simple Interest - Interest earned only on the original

More information

WHAT IS CAPITAL BUDGETING?

WHAT IS CAPITAL BUDGETING? WHAT IS CAPITAL BUDGETING? Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial

More information

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows

Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows Chapter 13 The Basics of Capital Budgeting Evaluating Cash Flows ANSWERS TO SELECTED END-OF-CHAPTER QUESTIONS 13-1 a. The capital budget outlines the planned expenditures on fixed assets. Capital budgeting

More information

Chapter 9 Capital Budgeting Decision Models

Chapter 9 Capital Budgeting Decision Models Chapter 9 Capital Budgeting Decision Models LEARNING OBJECTIVES (Slide 9-2) 1. Explain capital budgeting and differentiate between short-term and long-term budgeting decisions. 2. Explain the payback model

More information

CHAPTER 8 CAPITAL BUDGETING DECISIONS

CHAPTER 8 CAPITAL BUDGETING DECISIONS CHAPTER 8 CAPITAL BUDGETING DECISIONS Q1. What is capital budgeting? Why is it significant for a firm? A1 A capital budgeting decision may be defined as the firm s decision to invest its current funds

More information

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Basic 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After two years, the

More information

Capital Budgeting OVERVIEW

Capital Budgeting OVERVIEW WSG12 7/7/03 4:25 PM Page 191 12 Capital Budgeting OVERVIEW This chapter concentrates on the long-term, strategic considerations and focuses primarily on the firm s investment opportunities. The discussions

More information

Which projects should the corporation undertake

Which projects should the corporation undertake Which projects should the corporation undertake Investment criteria 1. Investment into a new project generates a flow of cash and, therefore, a standard DPV rule should be the first choice under consideration.

More information

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 6 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA Answers to Concepts Review and Critical Thinking Questions 1. Assuming conventional cash flows, a payback period less than the project s life means

More information

EXAM 2 OVERVIEW. Binay Adhikari

EXAM 2 OVERVIEW. Binay Adhikari EXAM 2 OVERVIEW Binay Adhikari FEDERAL RESERVE & MARKET ACTIVITY (BS38) Definition 4.1 Discount Rate The discount rate is the periodic percentage return subtracted from the future cash flow for computing

More information

Investment Appraisal

Investment Appraisal Investment Appraisal Article relevant to F1 Business Mathematics and Quantitative Methods Author: Pat McGillion, current Examiner. Questions 1 and 6 often relate to Investment Appraisal, which is underpinned

More information

PAYBACK PERIOD. Calculated as: Payback Period = Cost of Project / Annual Cash Inflows

PAYBACK PERIOD. Calculated as: Payback Period = Cost of Project / Annual Cash Inflows PAYBACK PERIOD CHRISTINE NYANDAT, 19 Nov, 2013 Definition: Payback period is the length of time required to recover the cost of an investment. The payback period of a given investment or project is an

More information

Key Concepts and Skills. Chapter Outline. Basic Definitions. Future Values. Future Values: General Formula 1-1. Chapter 4

Key Concepts and Skills. Chapter Outline. Basic Definitions. Future Values. Future Values: General Formula 1-1. Chapter 4 Key Concepts and Skills Chapter 4 Introduction to Valuation: The Time Value of Money Be able to compute the future value of an investment made today Be able to compute the present value of cash to be received

More information

BUSINESS FINANCE (FIN 312) Spring 2009

BUSINESS FINANCE (FIN 312) Spring 2009 BUSINESS FINANCE (FIN 31) Spring 009 Assignment Instructions: please read carefully You can either do the assignment by yourself or work in a group of no more than two. You should show your work how to

More information

Investment Decision Analysis

Investment Decision Analysis Lecture: IV 1 Investment Decision Analysis The investment decision process: Generate cash flow forecasts for the projects, Determine the appropriate opportunity cost of capital, Use the cash flows and

More information

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA

CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA CHAPTER 9 NET PRESENT VALUE AND OTHER INVESTMENT CRITERIA 1. To calculate the payback period, we need to find the time that the project has recovered its initial investment. After three years, the project

More information

(Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics)

(Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) Capital Budgeting: Net Present Value vs Internal Rate of Return (Relevant to AAT Examination Paper 4 Business Economics and Financial Mathematics) Y O Lam Capital budgeting assists decision makers in a

More information

NPV Versus IRR. W.L. Silber -1000 0 0 +300 +600 +900. We know that if the cost of capital is 18 percent we reject the project because the NPV

NPV Versus IRR. W.L. Silber -1000 0 0 +300 +600 +900. We know that if the cost of capital is 18 percent we reject the project because the NPV NPV Versus IRR W.L. Silber I. Our favorite project A has the following cash flows: -1 + +6 +9 1 2 We know that if the cost of capital is 18 percent we reject the project because the net present value is

More information

Chapter 8 Capital Budgeting Process and Techniques

Chapter 8 Capital Budgeting Process and Techniques Chapter 8 Capital Budgeting Process and Techniques MULTIPLE CHOICE 1. The capital budgeting process involves a. identifying potential investments b. analyzing the set of investment opportunities, and identifying

More information

Review Solutions FV = 4000*(1+.08/4) 5 = $4416.32

Review Solutions FV = 4000*(1+.08/4) 5 = $4416.32 Review Solutions 1. Planning to use the money to finish your last year in school, you deposit $4,000 into a savings account with a quoted annual interest rate (APR) of 8% and quarterly compounding. Fifteen

More information

Week- 1: Solutions to HW Problems

Week- 1: Solutions to HW Problems Week- 1: Solutions to HW Problems 10-1 a. Payback A (cash flows in thousands): Annual Period Cash Flows Cumulative 0 ($5,000) ($5,000) 1 5,000 (0,000) 10,000 (10,000) 3 15,000 5,000 4 0,000 5,000 Payback

More information

Part 7. Capital Budgeting

Part 7. Capital Budgeting Part 7. Capital Budgeting What is Capital Budgeting? Nancy Garcia and Digital Solutions Digital Solutions, a software development house, is considering a number of new projects, including a joint venture

More information

Net Present Value and Capital Budgeting. What to Discount

Net Present Value and Capital Budgeting. What to Discount Net Present Value and Capital Budgeting (Text reference: Chapter 7) Topics what to discount the CCA system total project cash flow vs. tax shield approach detailed CCA calculations and examples project

More information

2016 Wiley. Study Session 2: Quantitative Methods Basic Concepts

2016 Wiley. Study Session 2: Quantitative Methods Basic Concepts 2016 Wiley Study Session 2: Quantitative Methods Basic Concepts Reading 5: The Time Value of Money LESSO 1: ITRODUCTIO, ITEREST RATES, FUTURE VALUE, AD PREST VALUE The Financial Calculator It is very important

More information

MODULE 2. Capital Budgeting

MODULE 2. Capital Budgeting MODULE 2 Capital Budgeting Capital Budgeting is a project selection exercise performed by the business enterprise. Capital budgeting uses the concept of present value to select the projects. Capital budgeting

More information

Discounted Cash Flow Valuation

Discounted Cash Flow Valuation 6 Formulas Discounted Cash Flow Valuation McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Outline Future and Present Values of Multiple Cash Flows Valuing

More information

Global Financial Management

Global Financial Management 1 Global Financial Management Valuation of Cash Flows Investment Decisions and Capital Budgeting Copyright 1999 by Alon Brav, Campbell R. Harvey, Stephen Gray and Ernst Maug. All rights reserved. No part

More information

Chapter 7. Net Present Value and Other Investment Criteria

Chapter 7. Net Present Value and Other Investment Criteria Chapter 7 Net Present Value and Other Investment Criteria 7-2 Topics Covered Net Present Value Other Investment Criteria Mutually Exclusive Projects Capital Rationing 7-3 Net Present Value Net Present

More information

FinQuiz Notes 2 0 1 5

FinQuiz Notes 2 0 1 5 Reading 5 The Time Value of Money Money has a time value because a unit of money received today is worth more than a unit of money to be received tomorrow. Interest rates can be interpreted in three ways.

More information

Solutions to Chapter 8. Net Present Value and Other Investment Criteria

Solutions to Chapter 8. Net Present Value and Other Investment Criteria Solutions to Chapter 8 Net Present Value and Other Investment Criteria. NPV A = $00 + [$80 annuity factor (%, periods)] = $00 $80 $8. 0 0. 0. (.) NPV B = $00 + [$00 annuity factor (%, periods)] = $00 $00

More information

Investment, Time, and Present Value

Investment, Time, and Present Value Investment, Time, and Present Value Contents: Introduction Future Value (FV) Present Value (PV) Net Present Value (NPV) Optional: The Capital Asset Pricing Model (CAPM) Introduction Decisions made by a

More information

Tools for Project Evaluation. Nathaniel Osgood 1.040/1.401J 2/11/2004

Tools for Project Evaluation. Nathaniel Osgood 1.040/1.401J 2/11/2004 Tools for Project Evaluation Nathaniel Osgood 1.040/1.401J 2/11/2004 Basic Compounding Suppose we invest $x in a bank offering interest rate i If interest is compounded annually, asset will be worth $x(1+i)

More information

( ) ( )( ) ( ) 2 ( ) 3. n n = 100 000 1+ 0.10 = 100 000 1.331 = 133100

( ) ( )( ) ( ) 2 ( ) 3. n n = 100 000 1+ 0.10 = 100 000 1.331 = 133100 Mariusz Próchniak Chair of Economics II Warsaw School of Economics CAPITAL BUDGETING Managerial Economics 1 2 1 Future value (FV) r annual interest rate B the amount of money held today Interest is compounded

More information

3. Time value of money. We will review some tools for discounting cash flows.

3. Time value of money. We will review some tools for discounting cash flows. 1 3. Time value of money We will review some tools for discounting cash flows. Simple interest 2 With simple interest, the amount earned each period is always the same: i = rp o where i = interest earned

More information

Key Concepts and Skills

Key Concepts and Skills McGraw-Hill/Irwin Copyright 2014 by the McGraw-Hill Companies, Inc. All rights reserved. Key Concepts and Skills Be able to compute: The future value of an investment made today The present value of cash

More information

CHAPTER 4 DISCOUNTED CASH FLOW VALUATION

CHAPTER 4 DISCOUNTED CASH FLOW VALUATION CHAPTER 4 DISCOUNTED CASH FLOW VALUATION Solutions to Questions and Problems NOTE: All-end-of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to space and readability

More information

Time Value of Money 1

Time Value of Money 1 Time Value of Money 1 This topic introduces you to the analysis of trade-offs over time. Financial decisions involve costs and benefits that are spread over time. Financial decision makers in households

More information

CHAPTER 29. Capital Budgeting

CHAPTER 29. Capital Budgeting CHAPTER 9 Capital Budgeting Meaning The term Capital Budgeting refers to the long-term planning for proposed capital outlays or expenditure for the purpose of maximizing return on investments. The capital

More information

6 Investment Decisions

6 Investment Decisions 6 Investment Decisions After studying this chapter you will be able to: Learning Objectives Define capital budgeting and explain the purpose and process of Capital Budgeting for any business. Explain the

More information

Planning for Capital Investments

Planning for Capital Investments 12-1 Planning for Capital Investments Managerial Accounting Fifth Edition Weygandt Kimmel Kieso 12-2 study objectives 1. Discuss capital budgeting evaluation, and explain inputs used in capital budgeting.

More information

Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows ANSWERS TO END-OF-CHAPTER QUESTIONS

Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows ANSWERS TO END-OF-CHAPTER QUESTIONS Chapter 10 The Basics of Capital Budgeting: Evaluating Cash Flows ANSWERS TO END-OF-CHAPTER QUESTIONS 10-1 a. Capital budgeting is the whole process of analyzing projects and deciding whether they should

More information

How To Calculate Discounted Cash Flow

How To Calculate Discounted Cash Flow Chapter 1 The Overall Process Capital Expenditures Whenever we make an expenditure that generates a cash flow benefit for more than one year, this is a capital expenditure. Examples include the purchase

More information

BENEFIT-COST ANALYSIS Financial and Economic Appraisal using Spreadsheets

BENEFIT-COST ANALYSIS Financial and Economic Appraisal using Spreadsheets BENEFIT-COST ANALYSIS Financial and Economic Appraisal using Spreadsheets Ch. 3: Decision Rules Harry Campbell & Richard Brown School of Economics The University of Queensland Applied Investment Appraisal

More information

Economic Analysis and Economic Decisions for Energy Projects

Economic Analysis and Economic Decisions for Energy Projects Economic Analysis and Economic Decisions for Energy Projects Economic Factors As in any investment project, the following factors should be considered while making the investment decisions in energy investment

More information

Key Concepts and Skills. Multiple Cash Flows Future Value Example 6.1. Chapter Outline. Multiple Cash Flows Example 2 Continued

Key Concepts and Skills. Multiple Cash Flows Future Value Example 6.1. Chapter Outline. Multiple Cash Flows Example 2 Continued 6 Calculators Discounted Cash Flow Valuation Key Concepts and Skills Be able to compute the future value of multiple cash flows Be able to compute the present value of multiple cash flows Be able to compute

More information

TIME VALUE OF MONEY. Return of vs. Return on Investment: We EXPECT to get more than we invest!

TIME VALUE OF MONEY. Return of vs. Return on Investment: We EXPECT to get more than we invest! TIME VALUE OF MONEY Return of vs. Return on Investment: We EXPECT to get more than we invest! Invest $1,000 it becomes $1,050 $1,000 return of $50 return on Factors to consider when assessing Return on

More information

Sharp EL-733A Tutorial

Sharp EL-733A Tutorial To begin, look at the face of the calculator. Almost every key on the EL-733A has two functions: each key's primary function is noted on the key itself, while each key's secondary function is noted in

More information

2. Determine the appropriate discount rate based on the risk of the security

2. Determine the appropriate discount rate based on the risk of the security Fixed Income Instruments III Intro to the Valuation of Debt Securities LOS 64.a Explain the steps in the bond valuation process 1. Estimate the cash flows coupons and return of principal 2. Determine the

More information

THE TIME VALUE OF MONEY

THE TIME VALUE OF MONEY QUANTITATIVE METHODS THE TIME VALUE OF MONEY Reading 5 http://proschool.imsindia.com/ 1 Learning Objective Statements (LOS) a. Interest Rates as Required rate of return, Discount Rate and Opportunity Cost

More information

Calculator and QuickCalc USA

Calculator and QuickCalc USA Investit Software Inc. www.investitsoftware.com. Calculator and QuickCalc USA TABLE OF CONTENTS Steps in Using the Calculator Time Value on Money Calculator Is used for compound interest calculations involving

More information

DISCOUNTED CASH FLOW VALUATION and MULTIPLE CASH FLOWS

DISCOUNTED CASH FLOW VALUATION and MULTIPLE CASH FLOWS Chapter 5 DISCOUNTED CASH FLOW VALUATION and MULTIPLE CASH FLOWS The basic PV and FV techniques can be extended to handle any number of cash flows. PV with multiple cash flows: Suppose you need $500 one

More information

2. CAPITAL BUDGETING TECHNIQUES

2. CAPITAL BUDGETING TECHNIQUES 2. CAPITAL BUDGETING TECHNIQUES 2.1 Introduction 2.2 Capital budgeting techniques under certainty 2.2.1 Non-discounted Cash flow Criteria 2.2.2 Discounted Cash flow Criteria 2.3 Comparison of NPV and IRR

More information

Main TVM functions of a BAII Plus Financial Calculator

Main TVM functions of a BAII Plus Financial Calculator Main TVM functions of a BAII Plus Financial Calculator The BAII Plus calculator can be used to perform calculations for problems involving compound interest and different types of annuities. (Note: there

More information

Capital Budgeting Techniques: Certainty and Risk

Capital Budgeting Techniques: Certainty and Risk Capital Budgeting Techniques: Certainty and Risk 340 LG1 LG2 LG3 LG4 LG5 LG6 Chapter 9 LEARNING GOALS Calculate, interpret, and evaluate the payback period. Apply net present value (NPV) and internal rate

More information

Net Present Value and Other Investment Criteria

Net Present Value and Other Investment Criteria Net Present Value and Other Investment Criteria Topics Covered Net Present Value Other Investment Criteria Mutually Exclusive Projects Capital Rationing Net Present Value Net Present Value - Present value

More information

HO-23: METHODS OF INVESTMENT APPRAISAL

HO-23: METHODS OF INVESTMENT APPRAISAL HO-23: METHODS OF INVESTMENT APPRAISAL After completing this exercise you will be able to: Calculate and compare the different returns on an investment using the ROI, NPV, IRR functions. Investments: Discounting,

More information

Continue this process until you have cleared the stored memory positions that you wish to clear individually and keep those that you do not.

Continue this process until you have cleared the stored memory positions that you wish to clear individually and keep those that you do not. Texas Instruments (TI) BA II PLUS Professional The TI BA II PLUS Professional functions similarly to the TI BA II PLUS model. Any exceptions are noted here. The TI BA II PLUS Professional can perform two

More information

Project Management Seminars. Financial Management of Projects

Project Management Seminars. Financial Management of Projects Project Management Seminars Financial Management of Projects.inproject managementandsystems engineering, is a deliverable-oriented decomposition of a project into smaller components. (source: Wikipedia)

More information

Spring 2012. True/False Indicate whether the statement is true or false.

Spring 2012. True/False Indicate whether the statement is true or false. Corporation Finance Spring 2012 Sample Exam 2B True/False Indicate whether the statement is true or false. 1. The total return on a share of stock refers to the dividend yield less any commissions paid

More information

CHAPTER 11. Proposed Project. Incremental Cash Flow for a Project. Treatment of Financing Costs. Estimating cash flows:

CHAPTER 11. Proposed Project. Incremental Cash Flow for a Project. Treatment of Financing Costs. Estimating cash flows: CHAPTER 11 Cash Flow Estimation and Risk Analysis Estimating cash flows: Relevant cash flows Working capital treatment Inflation Risk Analysis: Sensitivity Analysis, Scenario Analysis, and Simulation Analysis

More information

Time Value of Money. 2014 Level I Quantitative Methods. IFT Notes for the CFA exam

Time Value of Money. 2014 Level I Quantitative Methods. IFT Notes for the CFA exam Time Value of Money 2014 Level I Quantitative Methods IFT Notes for the CFA exam Contents 1. Introduction...2 2. Interest Rates: Interpretation...2 3. The Future Value of a Single Cash Flow...4 4. The

More information

Course 3: Capital Budgeting Analysis

Course 3: Capital Budgeting Analysis Excellence in Financial Management Course 3: Capital Budgeting Analysis Prepared by: Matt H. Evans, CPA, CMA, CFM This course provides a concise overview of capital budgeting analysis. This course is recommended

More information

Measuring Investment Returns

Measuring Investment Returns Measuring Investment Returns Aswath Damodaran Stern School of Business Aswath Damodaran 156 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The

More information

1.3.2015 г. D. Dimov. Year Cash flow 1 $3,000 2 $5,000 3 $4,000 4 $3,000 5 $2,000

1.3.2015 г. D. Dimov. Year Cash flow 1 $3,000 2 $5,000 3 $4,000 4 $3,000 5 $2,000 D. Dimov Most financial decisions involve costs and benefits that are spread out over time Time value of money allows comparison of cash flows from different periods Question: You have to choose one of

More information

Cost Benefits analysis

Cost Benefits analysis Cost Benefits analysis One of the key items in any business case is an analysis of the costs of a project that includes some consideration of both the cost and the payback (be it in monetary or other terms).

More information

Basic Concept of Time Value of Money

Basic Concept of Time Value of Money Basic Concept of Time Value of Money CHAPTER 1 1.1 INTRODUCTION Money has time value. A rupee today is more valuable than a year hence. It is on this concept the time value of money is based. The recognition

More information

CARNEGIE MELLON UNIVERSITY CIO INSTITUTE

CARNEGIE MELLON UNIVERSITY CIO INSTITUTE CARNEGIE MELLON UNIVERSITY CIO INSTITUTE CAPITAL BUDGETING BASICS Contact Information: Lynne Pastor Email: lp23@andrew.cmu.edu RELATED LEARNGING OBJECTIVES 7.2 LO 3: Compare and contrast the implications

More information

Prepared by: Dalia A. Marafi Version 2.0

Prepared by: Dalia A. Marafi Version 2.0 Kuwait University College of Business Administration Department of Finance and Financial Institutions Using )Casio FC-200V( for Fundamentals of Financial Management (220) Prepared by: Dalia A. Marafi Version

More information

Chapter 11. Bond Pricing - 1. Bond Valuation: Part I. Several Assumptions: To simplify the analysis, we make the following assumptions.

Chapter 11. Bond Pricing - 1. Bond Valuation: Part I. Several Assumptions: To simplify the analysis, we make the following assumptions. Bond Pricing - 1 Chapter 11 Several Assumptions: To simplify the analysis, we make the following assumptions. 1. The coupon payments are made every six months. 2. The next coupon payment for the bond is

More information

Chapter 4. Time Value of Money

Chapter 4. Time Value of Money Chapter 4 Time Value of Money Learning Goals 1. Discuss the role of time value in finance, the use of computational aids, and the basic patterns of cash flow. 2. Understand the concept of future value

More information

Capital Investment Appraisal Techniques

Capital Investment Appraisal Techniques Capital Investment Appraisal Techniques To download this article in printable format click here A practising Bookkeeper asked me recently how and by what methods one would appraise a proposed investment

More information

Capital Budgeting Further Considerations

Capital Budgeting Further Considerations Capital Budgeting Further Considerations For 9.220, Term 1, 2002/03 02_Lecture10.ppt Lecture Outline Introduction The input for evaluating projects relevant cash flows Inflation: real vs. nominal analysis

More information

CHAPTER 8 INTEREST RATES AND BOND VALUATION

CHAPTER 8 INTEREST RATES AND BOND VALUATION CHAPTER 8 INTEREST RATES AND BOND VALUATION Solutions to Questions and Problems 1. The price of a pure discount (zero coupon) bond is the present value of the par value. Remember, even though there are

More information

APPENDIX 3 TIME VALUE OF MONEY. Time Lines and Notation. The Intuitive Basis for Present Value

APPENDIX 3 TIME VALUE OF MONEY. Time Lines and Notation. The Intuitive Basis for Present Value 1 2 TIME VALUE OF MONEY APPENDIX 3 The simplest tools in finance are often the most powerful. Present value is a concept that is intuitively appealing, simple to compute, and has a wide range of applications.

More information

Project Cost Management

Project Cost Management Project Cost Management Guide to Mathematical Questions PMI, PMP, CAPM, PMBOK, PM Network and the PMI Registered Education Provider logo are registered marks of the Project Management Institute, Inc. Present

More information

Chapter 5 Time Value of Money 2: Analyzing Annuity Cash Flows

Chapter 5 Time Value of Money 2: Analyzing Annuity Cash Flows 1. Future Value of Multiple Cash Flows 2. Future Value of an Annuity 3. Present Value of an Annuity 4. Perpetuities 5. Other Compounding Periods 6. Effective Annual Rates (EAR) 7. Amortized Loans Chapter

More information

Performing Net Present Value (NPV) Calculations

Performing Net Present Value (NPV) Calculations Strategies and Mechanisms For Promoting Cleaner Production Investments In Developing Countries Profiting From Cleaner Production Performing Net Present Value (NPV) Calculations Cleaner Production Profiting

More information

The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% = 5.216. = 3.93 years

The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% = 5.216. = 3.93 years 21-18 Capital budgeting methods, no income taxes. The table for the present value of annuities (Appendix A, Table 4) shows: 10 periods at 14% 5.216 1a. Net present value $28,000 (5.216) $146,048 $36,048

More information

CHAPTER 6. Investment Decision Rules. Chapter Synopsis

CHAPTER 6. Investment Decision Rules. Chapter Synopsis CHAPTER 6 Investment Decision Rules Chapter Synopsis 6.1 and Stand-Alone Projects The net present value () of a project is the difference between the present value of its benefits and the present value

More information

1.1 Introduction. Chapter 1: Feasibility Studies: An Overview

1.1 Introduction. Chapter 1: Feasibility Studies: An Overview Chapter 1: Introduction 1.1 Introduction Every long term decision the firm makes is a capital budgeting decision whenever it changes the company s cash flows. Consider launching a new product. This involves

More information

FinQuiz Notes 2 0 1 4

FinQuiz Notes 2 0 1 4 Reading 5 The Time Value of Money Money has a time value because a unit of money received today is worth more than a unit of money to be received tomorrow. Interest rates can be interpreted in three ways.

More information

CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS

CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS CHAPTER 7 MAKING CAPITAL INVESTMENT DECISIONS Answers to Concepts Review and Critical Thinking Questions 1. In this context, an opportunity cost refers to the value of an asset or other input that will

More information

How To Calculate The Value Of A Project

How To Calculate The Value Of A Project Chapter 02 How to Calculate Present Values Multiple Choice Questions 1. The present value of $100 expected in two years from today at a discount rate of 6% is: A. $116.64 B. $108.00 C. $100.00 D. $89.00

More information

Texas Instruments BAII Plus Tutorial for Use with Fundamentals 11/e and Concise 5/e

Texas Instruments BAII Plus Tutorial for Use with Fundamentals 11/e and Concise 5/e Texas Instruments BAII Plus Tutorial for Use with Fundamentals 11/e and Concise 5/e This tutorial was developed for use with Brigham and Houston s Fundamentals of Financial Management, 11/e and Concise,

More information

e C P M 1 0 5 : P o r t f o l i o M a n a g e m e n t f o r P r i m a v e r a P 6 W e b A c c e s s

e C P M 1 0 5 : P o r t f o l i o M a n a g e m e n t f o r P r i m a v e r a P 6 W e b A c c e s s e C P M 1 5 : P o r t f o l i o M a n a g e m e n t f o r P r i m a v e r a P 6 W e b A c c e s s Capital Budgeting C o l l a b o r a t i v e P r o j e c t M a n a g e m e n t e C P M 1 5 C a p i t a l

More information

1. What are the three types of business organizations? Define them

1. What are the three types of business organizations? Define them Written Exam Ticket 1 1. What is Finance? What do financial managers try to maximize, and what is their second objective? 2. How do you compare cash flows at different points in time? 3. Write the formulas

More information

Chapter 6. Discounted Cash Flow Valuation. Key Concepts and Skills. Multiple Cash Flows Future Value Example 6.1. Answer 6.1

Chapter 6. Discounted Cash Flow Valuation. Key Concepts and Skills. Multiple Cash Flows Future Value Example 6.1. Answer 6.1 Chapter 6 Key Concepts and Skills Be able to compute: the future value of multiple cash flows the present value of multiple cash flows the future and present value of annuities Discounted Cash Flow Valuation

More information

Discounted Cash Flow Valuation

Discounted Cash Flow Valuation Discounted Cash Flow Valuation Chapter 5 Key Concepts and Skills Be able to compute the future value of multiple cash flows Be able to compute the present value of multiple cash flows Be able to compute

More information

6. FINANCIAL MANAGEMENT

6. FINANCIAL MANAGEMENT 6. FINANCIAL MANAGEMENT Syllabus Financial Management: Investment-need, Appraisal and criteria, Financial analysis techniques-simple pay back period, Return on investment, Net present value, Internal rate

More information

18 CAPITAL INVESTMENT

18 CAPITAL INVESTMENT 18 CAPITAL INVESTMENT (Contributed by Deryl Northcott) Introduction Capital Investment Defined Who is Involved in Making CI Decisions? Why Are Capital Investment Decisions Important? Types of Capital Investments

More information